Markets require valuation guardrails because share prices and underlying corporate value can diverge sharply. In markets driven by enthusiasm, momentum, or fear, that gap widens quickly. Fundamental analysts question excessive valuations — selling or reducing positions when prices run ahead of fundamentals, and entering when pessimism overshoots.
For much of modern market history, active managers provided the bulk of this value-oriented capital. They did not prevent every bubble nor were they always right, but they offered a counterweight to momentum by questioning whether prices had over-reflected optimism or fear. That counterweight has weakened as fundamentally oriented investors hold a shrinking share of total market assets.
Passive investing has accelerated the shift. By the end of 2025, passive funds accounted for the majority of US long-term investment-fund and exchange-traded fund assets. This is not a criticism — passive investing has lowered costs and broadened access. But passive funds are designed to reflect prices, not challenge them.
When a company holds a larger share of an index, each new dollar flowing into a market-cap-weighted passive fund directs more capital into that company regardless of valuation. This creates valuation-ambiguous demand: rational for many investors, but only a limited force in price discovery. The market price is absorbed and passed through by fresh inflows.
That influence compounds when it meets other forces indifferent to valuation. Retail investors may be drawn by compelling narratives. Momentum strategies buy as prices rise. Professional fund managers face pressure not to underweight top performers. Leveraged ETFs add a mechanical layer, requiring regular rebalancing that increases exposure in rising markets and reduces it in falling ones — amplifying buying after price gains and selling after declines.
The process is most visible in rising markets. A company excites investors and its share price climbs, sometimes justified by stronger earnings, higher capital returns, or a larger addressable market. Risk emerges when the price begins to justify itself and expectations outpace what the business can deliver. As market value grows, the company gains weight in major indices. Passive inflows direct more capital into it. Momentum follows the price. Managers who question valuation come under pressure as the stock drives index returns. Success attracts capital, and capital reinforces success — the momentum inertia wheel.
The same cycle can reverse. When new buyers fade, confidence wanes and the stock price no longer supports the narrative. Momentum investors reduce exposure. Retail investors sell as the story loses appeal. Leveraged products trim positions. Passive funds continue to mirror prices rather than assess value.
The full cycle does not unfold as an orderly transition from overvaluation back to fair value. Prices can overshoot in both directions. On the way up, fundamental analysts may spot elevated valuations but lack sufficient influence to halt the rally. On the way down, selling is driven less by a revised fair-value assessment than by fading confidence, risk reduction, and liquidity needs. Momentum can overshoot both ways.
A great company can still be a poor investment if too much has already been priced in. Former winners may remain excellent businesses, but if expectations rise too far, future returns can disappoint.
When valuation regains influence, the market asks a different question: not which companies have risen fastest, but which are worth more than the market believes. This matters only if corporate value persists. Some declining stocks deserve to fall; others are punished beyond what fundamentals justify.
Companies that have fallen out of favor may have strengthened balance sheets, improved capital returns, and grown profits — all without attracting attention. They need investors willing to look past recent developments and question whether the market has become too pessimistic.
Passive investing benefited investors, but markets also need participants whose task is not to replicate indices but to question them. That role belongs to fundamentally oriented investors when valuation becomes relevant again.
Valuation never disappears. It simply loses importance for a period.
David Goodman is a fund manager in the Global Equities team at Liontrust in London. He previously worked at asset manager GAM from 2009 to 2024, beginning his career as an equity derivatives trader at Citigroup.
